The management of liquidity risk in Islamic banks : the case of Indonesia

Abstract

Islamic banking and finance has shown progressive development all over the world since its inception as a commercial banking model in mid-1970s. Indonesia, as the largest Moslem nation in the world, has initiated some policies to expand the Islamic banking industry in the country. Similar to conventional banks, Islamic banks face a number of risk areas, which may affect their performance and operations. One of such risk areas is liquidity risk, which shows additional features in the case of Islamic banks. Both the international banking standards and the Sharia guidance suggest that banks should have: robust liquidity risk management policies, a responsive asset and liability committee, effective information and internal control systems and, methods for managing deposits to reduce on-demand liquidity, to manage liquidity risk. The aim of this research, hence, is to analyze the management of liquidity risk in Islamic banks through balancing assets and liabilities with the ultimate objective to recommend policies to improve the management of liquidity risk. This aim is fulfilled in the case of Indonesian Islamic banking industry. The data collection and analysis method in this research involve triangulation method with a combination of quantitative and qualitative methods to achieve such aim and objective. Particularly, both the performance analysis of the industry and the econometric time series analysis were conducted to analyze the liquidity risk and its management for Islamic banking, which includes the liquidity behavior of banking depositors and Islamic banks. In addition, the primary data through questionnaire survey was also assembled with the aim of knowing the actual practices and problems of managing liquidity risk. It was investigated from the perceptions of Islamic banking depositors and Islamic bankers to shed further lights on the liquidity risk issues, which were not captured in the time-series analysis. The empirical analyses conducted in this research demonstrate: (i) the non optimal organizational structure of Islamic banks to manage liquidity, (ii) the significant demand for liquidity withdrawals from depositors and fragility of Islamic banks to mitigate certain scenarios of liquidity withdrawals, (iii) critical factors explaining liquidity behavior of banking depositors and Islamic banks, (iv) reasons for depositors to withdraw funds from Islamic banks and the non ideal management of funds by Islamic banks and, (v) the limited Islamic money market instruments to manage the demand for liquidity from depositors. Based on these findings, the research then constructs an integrated and comprehensive program to manage liquidity risk, which consists of three elements: (i) institutional deepening, (ii) restructuring the management of liquidity on the asset and liability sides and, (iii) revitalizing the usage of Islamic liquid instruments. This integrated and comprehensive program of liquidity risk management recommends a better way of managing liquidity risk based on Sharia compliant instruments and international standard banking practices

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